Using reasonable business plan assumptions is critical - Published in the SB News Press in May of 2011

The process of writing a high-quality, effective business plan involves many key steps.  Throughout the process, the writer must make numerous assumptions about the future needs and performance of the company.  Often, business owners feeling optimistic about the prospects for their business, and make optimistic assumptions that may be unrealistic.  Even one unrealistic assumption can stop a potential investor or lender in their tracks, resulting in a lost opportunity for the business owner to secure the funding they need.

There are multiple reasons for an entrepreneur to write a business plan.  Securing funding for a startup or business expansion certainly requires a top-quality, professionally written plan.  Often writing a plan is a means by which the entrepreneur can decide if the business concept is financially viable.  Another reason for having a good plan is to secure a long-term lease.  Still another reason is to examine the current operations of the business to determine why the business is not achieving targets, or to identify opportunities for improvement.  The structure of the plan can change, depending on the purpose of the plan.  To a limited extent, the assumptions used in the plan will vary, depending on the purpose of the plan.

One way to organize assumptions is to divide them into two broad categories—revenue assumptions and expense assumptions.  Within revenue assumptions, the business owner needs to determine all of the possible revenue drivers the business will have, not just today, but into the future.  A good business plan will contain a financial model with at least 3 years of pro-forma statements and supporting tables, and preferably 5 years of data.  If using a 5-year pro-forma, the entrepreneur should spend some time thinking-through the coming five years to determine all of the potential revenue producing activities of the business he or she expects during that time-frame. 

Once all revenue drivers have been identified, each can be projected using a detailed revenue model.  This is where the assumptions come into play.  For each revenue driver, the entrepreneur must determine when the specific revenue source will begin to produce sales.  Next, the magnitude of those sales, as well as a reasonable growth rate, must be assumed.  Using a spreadsheet program, such as Excel, the business owner must then project the estimated revenues from that source for the coming 5 years.  While using annual assumptions and estimates is adequate in some instances, a monthly or at least quarterly pro-forma is much preferred. 

Once each and every potential revenue driver has been evaluated, specific assumptions have been identified for each, and each has been modeled for the entire five-year period, a complete revenue model can be created using the spreadsheet program.  I find it very helpful and time-saving to take the time to write formulas into the spreadsheet so that, if I need to make adjustments to my assumptions later, I can simply change the assumptions, and don’t have to completely recreate the spreadsheet from scratch.  I do this by creating a “Drivers” page, which contains all of my assumptions on one page, and then I write my formulas referencing those drivers.  Then, if any changes are needed (and there are always changes needed), I can simply go to the drivers page and change the assumptions; automatically updating all of my pro-formas.

Using at least quarterly estimates, and preferably monthly estimates, offers some significant benefits and realism to your pro-formas.  First, you may have a business that experiences seasonality.  For example, if you are in Santa Barbara, and your business caters to tourists, you will likely experience more sales during the summer months than during winter.  If this is the case, you will definitely want to create a monthly revenue model that accurately reflects these fluctuations in your revenues.  Most businesses have at least some fixed costs, so if revenues fluctuate and costs remain fixed, cash flow can get strained.  Investors and lenders will want to know that you have taken this into account, and that your financials reflect this reality.

A second and equally important reason to use a more detailed financial projection is to show the monthly assumed growth in revenues.  Most businesses, and especially startups, will experience rapid growth on a monthly basis during their first few years of operations (at least we hope this will be the case).  It is difficult if not impossible to accurately reflect growth using only annual projections.  At a minimum, the reader will not get a true sense of the pace of growth from reviewing solely the annual projections.  While we want our plan to accurately reflect growth on a realistic basis, we also want to convey the excitement of the growth of the business to potential investors and lenders.

Once revenues have been accurately modeled, based on realistic assumptions, we can move on to expenses.  This is a much broader category because it includes not just operating expenses, but also your start-up costs as well, if the business is new.  (If expanding a business, there will be upfront costs associated with the expansion as well.)

For a startup or expansion, some of the expenses to keep in mind are equipment costs, construction costs, initial inventory costs, hiring costs, initial lease or building purchase costs including deposits, licenses, permits, broker fees, etc.  For each of these costs, the business owner can usually get accurate estimates either from quotes obtained from suppliers, sellers, vendors, brokers, etc., or from doing some fairly simple research in the local market where the business will be located.  For Internet-based businesses, or businesses that will have a web presence, there will typically be website development expenses, domain name acquisition costs, etc.

Ongoing operating expenses include your cost of goods sold (COGS), labor costs, payroll services, payroll taxes, sales taxes, consumption taxes, rent, utilities, property maintenance costs such as CAMs (Common Area Maintenance), credit card processing fees, marketing expenses, professional fees, website hosting and maintenance, and marketing costs, insurance, security costs, depreciation/amortization, supplies, miscellaneous expenses, taxes, etc.  For each of these, the entrepreneur must make key assumptions for the entire 5-year period.  Typically as volumes increase, COGS and some other costs, will come down somewhat, so it is important to include efficiency gains in your model.  Taxes must include your effective tax rate for both federal and state taxes.  You may also have other taxes and/or fees associated with doing business in other states or countries.  If your business will show losses for some time up-front, the tax-loss carry-forward should be included in the model.

As mentioned above, seasonality and growth rates must be consistently modeled throughout the financials, so any impact that these factors have on expenses must be accurately and completely modeled within the financials, with proper assumptions for each.  Only by making appropriate assumptions and modeling all revenues and expenses on a monthly basis will the business plan truly reflect the potential performance of the business for the reader.

The final, but equally important point is to provide a thorough, detailed explanation of all assumptions used in the financial model and plan overall.  Do not assume that the reader will understand anything about GAAP accounting principles, industry norms, local operating conditions, etc.  Lay everything out for the least common denominator reader.  I always assume the reader doesn’t know anything about the business and has weak financial and accounting skills at best.  It is better to be safe than sorry.  First impressions, when it comes to investors and lenders, are everything.  Put your best foot forward by providing a detailed, well-conceived, accurate financial model and complete business plan, based on realistic assumptions that are appropriate for the business, industry, operating environment, and current economic conditions, and you will have the best possible chance to secure funding, and to build your business to success!

Long maturities could be costly for bondholders - Published in the SB News Press in May of 2011

With interest rates at historic lows and inflationary pressures mounting, bondholders owning bonds with long maturities may need to consider shortening those maturities.  If (when) interest rates begin to rise, bond prices will decline.  More importantly bonds with longer maturities will tend to decline much more than those with shorter maturities.  There are certain characteristics of bonds, however, that make the impact of rising interest rates more or less dramatic, in terms of price declines.

The Federal Reserve (The Fed) has held short rates at basically zero percent for over two years, going back to December 16, 2008.  In addition, the Fed and the Treasury Department have been doing all sorts of things to stimulate the economy, such as quantitative easing – buying securities like treasuries and mortgage-backed bonds to pump additional cash into the economy.  The theory behind all of this is that more cash in the economy with low rates will push consumers and businesses to spend more money (because there is more of it around, so it is (theoretically again) easier to come by. 

Lower interest rates definitely make the cost of borrowing lower, at least for those individuals and businesses that can qualify for loans.  However, the problem with all of this “easy money” is that it can drive inflation.  In fact, that is exactly what we are starting to see take place.  Commodity Prices have been at very elevated levels for many months now.  Although many companies that use commodities as inputs or raw materials in the production of goods are able to hedge some, or in some cases all of the risk of commodity price increases away, after a while, the contracts they are using for their hedges expire.  This means that they are no longer able to hedge as much, or possibly any, of the price increases away. 

Once commodity prices stay elevated for extended periods, producers experience rising input costs, and therefore must either pass-on those costs, or part of those costs to the consumer, or their profit margins get squeezed.  Higher prices to the consumer mean that consumers can and will buy less.  They buy less partially because they have less buying power since prices have increased, and partly because they don’t feel good about the economy and prices increasing.  Businesses therefore lose sales, which means their revenues and profits will be lower. 

If a company is unable to pass-on the cost increase of their inputs, their profits get squeezed, making their stock value decrease, their ability to borrow erode, and making their internally-generated cash available for research and development, expansion, hiring, purchasing other companies, etc., decrease.

To combat the negative impacts to the economy of inflation, the Fed will be forced to begin raising rates, and may even need to reduce the money supply by backing out of some of the quantitative easing they have undertaken recently.  Once rates begin to rise, there can be, and very likely will be, negative consequences to the economy and for investors.  If the Fed can raise rates gradually, in a controlled and well-planned manner, it is certainly possible that the economy can continue to grow at a modest, but acceptable pace.  That will certainly be the game plan of the Fed.  However, if the Fed waits too long before beginning to raise rates, or if inflation gets too far out of control, the Fed will be forced to raise rates more quickly than they would like to, and this could have devastating consequences for the economy, businesses, consumers and investors.

One of those unfortunate and costly consequences will be the negative impact on bond prices.  Bond prices generally move in the opposite direction to interest rates—if rates go up, bond prices go down, and vice-versa.  One of the positive outcomes of the weak economy and the reduction of interest rates over the past few years has been the positive impact that falling rates has had on bond prices.  In fact, many bond investors and bond fund managers have performed exceptionally well during this time.  Unfortunately, the majority of positive performance has come from those falling rates, and not because of the expertise of the manager (at least in most cases).

Now that rates have bottomed, the economy appears to be recovering, and inflation is heating up, we should see rates begin to move higher across the yield curve—the spectrum of interest rates based on the maturities of the various types of bonds, such as treasuries.  When we talk about the yield curve, we are typically discussing the U.S. treasuries yield curve.  The treasury yield curve starts at zero, moves up to 0.5% at the two-year maturity, to about 1.8% at the five-year, to 3.2% at the ten-year, and to 4.3% at the thirty-year.  The curve is relatively flat at the moment, meaning the difference between the short end and the long end is not all that large.

What tends to happen when inflation heats up is that the longer end of the curve—the part that the Fed cannot manipulate, will begin to move up in yield, reflecting the higher perceived risk in the economy.  In order for this to happen, bond prices must fall (remember that inverse relationship—bond price moves the opposite way as interest rates).  The curve will tend to steepen, meaning that the difference or spread between short maturities and long maturities will increase, sometimes dramatically if inflation is strong.  This steepening will tend to pull the short end of the curve up, even if the Fed doesn’t change the Fed Funds rate.  (Remember that the Fed can only set a target rate.  The market actually determines where rates are at any point in time.)

As the curve both steepens, and shifts higher, bond prices move down across maturities.  However, longer maturities will tend to experience much greater price declines, since the change in longer rates will typically be much more pronounced.   There are several reasons for this difference between the impact on bonds with short maturities and those with long maturities.  First, because owners of long maturity bonds are stuck in them for a longer period of time, their risk is greater, so they are more likely to want to get out if things start to go south as compared with bondholders in shorter maturity bonds.  Those in the shorter maturities can wait it out, holding their bonds to maturity if need be, since the time to maturity is relatively short.  Those in the thirty-year bonds, have to wait for thirty years to get out.  Psychologically this is a big negative, and will tend to push more of those long maturity holders to want to sell.  More selling means a bigger price decline.

Another interesting driver for long maturity bond price declines in a rising interest rate environment is duration.  Duration is the weighted average of the times until the fixed cash flows from the bond are received. Duration also measures the price sensitivity to yield, or the percentage change in price for a parallel shift in yields.  Without making your eyes cross with a bunch of math, the point of duration is taking the weighted average of all of the cash flows that the owner of the bond will receive during the entire life of the bond.  The easiest way to think of duration is to look at a zero coupon bond.  No cash flows are received on a zero coupon bond until it matures, at which time all interest earned during the life of the bond, plus the principal is returned to the investor.  A zero coupon bond, for a given maturity, has the longest duration because all cash flows are received at maturity—at the very end of the bond’s life.  Because, in general, longer maturity bonds have longer durations, they are impacted more significantly in price when rates move up or down.

If you agree with me that interest rates have only one direction to move and that is up, and that rates will begin to move up sooner rather than later, then if you are a bondholder, you may want to consider whether you should hold long maturity bonds.  There are many reasons why investors own bonds, or any investment for that matter.  Each investor must make their own decisions based on their own needs.  However, I believe that long maturity bonds will suffer as rates rise and will suffer much more than short maturity bonds.  Anyone owning long maturity bonds should at least consider this when making portfolio decisions.

Inflation: If only we could “Ex” food and energy - Published in the SB News Press in May of 2011

Last week I wrote about inflation, deflation and stagflation, all of which can be serious challenges to an economy.  In this week’s column, I will address the components of inflation, and discuss how inflation and its component parts affect the everyday citizen.

The measurement of inflation, like so many economic indicators we read about and hear about on the news, is complex.  Often, the way these indicators are calculated becomes so convoluted that they no longer relate to the average person’s daily life.  Additionally, there are adjustments that are made to some indicators, which are thought to be necessary to “smooth” the data over time (to make it more meaningful as a series of numbers).  The reasoning for these adjustments only makes sense in the context of evaluating trends for the broad economy over time, and does not help the average person understand the day-to-day impact that the changes to these indicators has on their lives.

The Consumer Price Index (CPI) is the most recognized and most often discussed indicator for consumer-level inflation, while the Producer Price Index (PPI) is the indicator most often used for producer-level inflation.  The CPI is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.  This market basket of goods and services is kept constant so that the prices of that basket can be compared over time to track price changes and thereby track inflation (or deflation).  The calculation of inflation indicators, as with most economic indicators, has evolved over time, as the economy has become more developed and complex.  The tough part for the average person is that the basket of goods may or may not represent what the average person buys on a monthly basis.

The government’s Bureau of Labor Statistics, which is responsible for calculating the CPI, releases information on inflation each month.  Their most recent report for March CPI was released on April 15^th, and showed that consumer-level inflation rose 0.5% in March.  This CPI reading was for “all urban consumers,” and was calculated on a seasonally-adjusted basis.  “All urban consumers” means that the government is measuring the average inflation on the consumer level within cities as opposed to rural consumers (who have somewhat differing spending habits).

The government adjusts their readings based on the time of year to smooth the data, or, in other words, to take out of the calculation the impact of the season of the year within which the inflation occurred.  Various things happen at different times during the year that speed up or slow down the economy, so to try and get a more accurate reading of the true level of inflation, the government makes adjustments to offset these seasonality factors.

The “All Items Index” increased 2.7 percent over the past 12 months, before seasonal adjustment.  “All items” simply means that the entire basket of good is included in the calculation.  There are other specialized calculations that remove some items to attempt to get more usable data (more on this below). 

Gasoline and food prices continued to rise in March and together accounted for almost three quarters of the seasonally adjusted all items increase in March.  The gasoline index (a specialized inflation measure) posted its ninth consecutive increase and has now risen 14.4 percent over the last three months. The household energy index  rose as well, with advances in the fuel oil and electricity indexes more than offsetting a decline in the index for natural gas. The food at home index continued to accelerate in March, rising 1.1 percent as all six major grocery store food groups increased.

These specialized inflation indexes remove some of the goods in the all items basket to focus on one area of inflation.  These indexes are useful tools for economists who are trying to get a better sense of the component parts of inflation—what specific areas of the economy are increasing or decreasing in price.  These individual price shifts can help us to understand where supply and/or demand is increasing or decreasing, from month to month, or year to year.

The index for all items less food and energy rose 0.1 percent in March, a smaller increase than in the previous two months.  The CPI index, ex food and energy is referred to as “core” inflation and is the measure most often cited as the best measure of “real” inflation over time.  Food and energy have been volatile historically, and tend to fluctuate more than other commodities.  By removing them from the CPI calculation, economists get a better sense of the longer-term trend in inflation (without the month-to-month interference of dramatic changes in food and energy prices). 

As stated above, in so many areas of economics and finance, the information made available to the public, although better than nothing, is really intended for economists and financial analysts to measure broad-based economic trends, to understand the state of the financial markets, the money supply, imports and exports, and the like.  This information is really not formatted for the average citizen to use, to help them understand how the changes we are experiencing in the economy are going to affect their daily lives. 

As an example, core CPI—again removing food and energy from the calculation—might help economists understand the long-term trend in inflation, but it doesn’t do much for those of us who have to buy food and energy on a regular basis.  We care about monthly fluctuations in food and energy prices because we are forced to buy these commodities every month! 

The spike in oil prices in mid-2008, when crude spiked to almost $150 per barrel is a prime example.  While that spike in oil prices was short-lived, and oil fell back to the $30s by December (six months later), many consumers were running out of gas on freeways all across the nation because they could not afford to put gas in their cars.  Many consumers were living paycheck to paycheck, and the jump in fuel prices was enough to cause them to run out of money in between pay periods. While it may make sense for economists to remove that spike in oil prices from the calculation of core inflation, (so that they can see the “true” long-term trend over time), the average citizen didn’t feel any better about their bank account dwindling.

As we move into the summer driving season, we are already seeing gasoline prices approach $5 per gallon at the pump.  There are many factors that affect gasoline prices, and some pundits are claiming that we will see a $0.25 per gallon decrease in prices shortly.  I am skeptical.  Due to the weaker dollar, countries in Europe and elsewhere are actually buying gasoline from U.S. refiners (because it is cheaper in euros, etc.)  This increased demand is putting upward pressure on prices.  Also, refiners are not operating at full capacity, because demand, frankly, has been very weak. 

One of the most frustrating ironies of the current commodity price bubble is that inventories are very high for oil and many other commodities and demand is low.  These conditions should result in lower prices, but due to a variety of factors, including the weak dollar, prices are at historic highs for most commodities.  More disturbing is the fact that we have now experienced high commodity prices for such an extended period of time that, even if prices fall and stay low, we will very likely see elevated prices at the pump, grocery store, retailer, etc., for a long time to come because the input prices for manufacturers have forced them to pass-on their higher costs to us.

I believe that the Fed will be forced to begin raising interest rates very soon. This should pressure commodity prices as the dollar will strengthen and economic activity will slow, bringing at least domestic demand down.  However, the prices we face in our everyday lives will very likely remain high for a long time to come, even though the monthly measures of inflation will indicate that inflation is under control.

Inflation, Deflation, and Stagflation: What’s the difference? - Published in the SB News Press in May of 2011

We often hear economic and financial terms like inflation, CPI, opportunity cost, derivative, option, and the like, with economists, analysts and market pundits rattling them off as if we are all supposed to know what these words mean and how all of these concepts interact to drive our economy and financial markets.  The reality is that few of these so-called experts really understand these concepts, especially their practical implications and real-world impact on our daily lives.  A discussion of inflation, deflation, and stagflation, although probably a bit dry for most readers, can offer insights into the risks we face with the U.S. economy and investment portfolios.

Inflation is a rise in the general level of prices of goods and services in an economy over a period of time.  As prices rise, (assuming the value of the local currency does not change), consumers receive less value for each dollar spent.  A simple example would be if a gallon of milk initial costs $4 and then prices doubled to $8 for a gallon, the consumer would only get a half-gallon for the same $4 that previously got them a full gallon.  Another way to look at inflation is that consumers have to work harder and earn more to be able to buy the same amount of goods and services. 

Some inflation is fine.  In fact, a relatively low level of inflation is the most common economic condition for most countries, including the U.S.  Over the very long-term, the U.S. economy has experienced, on average, about 3 percent annual inflation.  A reasonable level of inflation can typically be offset by a rise in incomes.  We are all familiar with the “cost of living” pay raise.  This type of pay increase is intended to offset inflation—to maintain the employee’s buying power as the general level of prices rises.

Problems begin to occur when inflation rises at more than the normal pace.  The most basic negative impact is on consumers, as stated above.  Things begin to go progressively worse as inflation accelerates.  By definition, inflation means that the value of the currency weakens—you get less stuff for each dollar spent, so the dollar, (if we are talking about the U.S. economy), becomes progressively weaker as inflation increases.  A weakening currency can offer some positives, especially for companies that export—it makes their goods less expensive to foreign buyers.  However, as the currency weakens further and further, serious problems begin to arise.

Foreign investors will no longer want to invest in the U.S. as the dollar weakens, because their returns are denominated in dollars, which means that, when they try to bring their money back to their home country, they will have to convert their dollars to their home currency at a less and less favorable exchange rate.  At the moment, China holds something like $1.25 trillion (some say more than $2 trillion) is U.S. treasuries.  Imagine the negative impact on our economy if the Chinese should decide not to buy our debt anymore.  How would we replace that $2 trillion?

Another negative impact of a weakening dollar (as the result of inflation), is that consumers, who are receiving less and less for their dollars, just stop buying much of anything, other than necessities.  This can crush economic growth.  If the dollar weakens past a certain point, consumers will no longer want to hold dollars, and will resort to gold or even foreign currencies as a substitute.  Often, when currencies devalue, consumers resort to a barter system—trading goods and services directly, rather than using money.  This is an extreme situation, but it has happened in plenty of other countries. 

Hyperinflation is a condition where the currency of a country devalues to the point where it becomes virtually worthless, typically resulting in a complete collapse of the country’s economy.  In fact, we have had two instances of hyperinflation in the U.S:

1.)   The Continental Congress issued paper currency during the Revolutionary War, which was widely counterfeited, leading to the expression “not worth a continental;”

2.)  During the Civil War, the Confederate side printed currency which also devalued dramatically as their prospects dwindled towards the end of the war.

Deflation is the opposite of inflation—price levels decrease, usually as a result of weak demand.  Deflation is generally associated with recessions and depressions—consumers, worried about the economy, or who are out of work, stop spending money.  The result is a decline in demand for goods and services.  Less demand means that producers must lower prices to entice consumers to buy their goods and services.  The lower demand goes, the lower prices must go to generate sales.  If the price of goods falls below the cost to produce them, the economy could collapse. 

A deflationary spiral is a situation where decreases in price lead to lower production, which in turn leads to lower wages and demand, which leads to further decreases in price.  This vicious cycle can continue until the economy spirals down into a depression, such as the Great Depression.

Typically, when deflation occurs, (when we have a recession), the Federal Reserve will lower interest rates, as they did in the most recent recession, to stimulate demand.  By lowering the cost of money (the cost to borrow), usually (not always) more people will borrow and then spend, resulting in increasing demand and a stabilization of prices.  Low interest rates can cause inflation though, because lower rates usually end up causing demand to increase until prices begin to increase, and cause currencies to fall in value, etc. etc. 

Stagflation is probably the most serious possibility of the three discussed.  Stagflation occurs when the economy is stagnant, but still experiences high inflation.  This presents a conundrum for policymakers because the tools they would typically use to fight inflation—namely raising interest rates—will make the economy even worse.  The tools they would use to improve economic growth—namely lowering interest rates, increasing the money supply by printing more dollars, and open market operations, such as buying treasury securities, etc.—will result in even higher inflation. 

Stagflation can result when the productive capacity of an economy is reduced by an unfavorable supply shock, such as an increase in the price of oil. Such an unfavorable supply shock tends to raise prices at the same time that it slows the economy by making production more costly and less profitable.  Both stagnation and inflation can result from inappropriate macroeconomic policies. For example, central banks can cause inflation by permitting excessive growth of the money supply, which we have seen in the U.S. recently, as a result of the recession.  The government can also cause stagnation by excessive regulation of goods and labor markets.

In the 1970s, the U.S. economy experienced stagflation, which resulted from a big spike in oil prices.  Problems continued when the Fed used excessively stimulative monetary policy to counteract the resulting recession, causing a runaway wage-price spiral. 

Federal Reserve chairman Paul Volcker very sharply increased interest rates from 1979-1983 in what was called a "disinflationary scenario." After U.S. prime interest rates had soared into the double-digits, inflation did come down.  Rates skyrocketed to the highest levels in modern history.  Volcker is often credited with having stopped at least the inflationary side of stagflation, although the American economy also dipped into a deep recession.  Unemployment remained at elevated levels for six years, although the economy began to recover in 1983, after the double-dip recession.  This was one of the darkest times in U.S. economic history. 

There are certainly some signs of possible stagflation developing today.  We have extraordinarily high commodity prices, including a big spike in energy prices.  We do have economic growth, although the pace is fairly slow and we could easily dip back into recession.  The dollar is incredibly weak, which could lead to more inflation, although inflation is tame at the moment.  Rates are at historically low levels, as a result of the Fed holding short rates at basically zero for a prolonged period of time, which is pressuring the dollar, and they have increased the money supply dramatically. 

My concern is that, if the Fed does not act quickly to begin raising rates, it could be too late for them to do so at a moderate pace.  What we don’t want to see happen is the Fed jumping rates up by a substantial amount in a short period of time, which would almost certainly crush the recovery and could set us up for stagflation.  I believe the Fed should have already started raising rates, and I hope they do so very soon to avoid these very real, negative economic consequences.

Will the other shoe drop for real estate? - Published in the SB News Press in April of 2011

When I moved to California from Texas in 1993, the real estate market was just finding its bottom, after the excesses of the Savings & Loan debacle and the peak in prices around 1990/91.  Prices would stay at their lows until late in 1996, when they finally started to rebound.  I didn’t realize it at the time, but I had moved to California at the perfect time to buy real estate, with prices having just suffered such a tremendous collapse… or so I thought.  A more in-depth analysis of the conditions surrounding that 1993 price-point low, and a comparison to today’s real estate market, may shed some light on this issue, and may provide some insights into the attractiveness of real estate today.

The real estate boom of the late 1980s/early 1990s was driven, in part, by excess building, fueled by savings & loans, primarily in Texas and California, that were issuing high-yield (junk) bonds to raise the capital that they, in turn, lent to developers, speculators and buyers.  Like most bubbles that expand until they burst, this real estate cycle was driven by many factors all culminating in skyrocketing prices on the way up, and the inevitable crash we witnessed. 

Median home prices in California reached their peak in July of 1991, at around $206,000 (Santa Barbara peaked the month before at around $277,000).  By February of 1996, the California median home price had fallen to $170,000, or by about 17.5%.  In Santa Barbara, the media price declined to a low of about $170,000 in December of 1994, and was at $231,000 by February of 199, when the state hit its low, representing a 39% drop for Santa Barbara from the high to the low.

Prices in California did not surpass the $200,000 mark until May of 1998, almost two-and-a-half years after hitting bottom, and almost 7 years after the previous peak.  Santa Barbara prices surpassed the $277,000 high by June of 1996, only about one-and-a-half years after the bottom, but about 5 years after the previous peak.

What was so completely different about the current real estate bubble (that just burst) in comparison to the previous boom and bust cycle for real estate (1988 or so through 1996), is interest rates.  Even as real estate prices were rising dramatically back in 1988 and 1989, the 30-year fixed-rate mortgage rate was around 10 to 11 percent.  This contrasts sharply with rates during the 2006 and 2007 period, which were hovering around 6.5 to 7%.  In fact, even after prices began dropping, and while they continued to drop well into the 1993 through 1996 period, when real estate was hitting its lows, rates were still very high in comparison to where they are today.  Even in 1993 at the depths of the real estate declines, the 30-year fixed-rate mortgage was still running between 7 and 8 percent. 

I first moved to La Jolla from Texas in late 1993.  I was told that it was a good time to buy real estate, and that prices had just been hammered.  The first place I rented was owned by the builder, right at Wind-n-Sea Beach.  It was a 3-story duplex, which was only about one-year old.  It was about 2,000 square-feet and had a roof deck with tremendous views.  The owner was asking $385,000 at the time and no one would even look at it.  He begged me to buy it. I could not wrap my mind around paying almost $400,000 for a duplex (half of a duplex really), when in Texas, I could have bought a 5,000 square-foot house on 10 acres for that amount. 

I lived in the duplex for 2 years.  The owner lowered my rent while I was there so that I would allow him to show the unit.  No one cared.  He eventually sold it, years later, probably for substantially less than he was hoping to get in 1993. 

I am sure that place was worth $1.5 to $2 million during the latest boom.  I have always wondered if I made a huge mistake by not buying that place when I had the chance to get it cheap.  I often thought back about that place, and have felt like an idiot, knowing how much it’s worth today, even after the recent declines.

But did I really make a big mistake?  On closer examination, I am not so sure I did.  Starting in 1994, rates were climbing, and were already pushing 9 percent by the end of the year.  (Rates did come back down somewhat, to around 7.5% by the end of 1995, but went right back to around 8.5% by the middle of 1996.)     Using 8.5% as our assumed mortgage rate, and $400,000 as our loan amount, the monthly mortgage payment would have been about $3,850.  At the time (1994), I was paying $1,600 per month in rent, so the idea of assuming a $4,000 monthly mortgage payment was a bit scary to say the least (which is the key reason I didn’t buy anything).  Of course, there are some tax benefits to buying, especially in the early years of the loan, but even so, the next difference between renting and buying was still significant and therefore a huge deterrent. 

There would not have been an attractive opportunity to refinance at a lower rate until 1998 – 4 years later.  Which means that I would have been stuck making that $4,000 payment every month for at least 4 years – a pretty scary situation for a guy working on straight commission as a stockbroker at the time.  But, at least eventually I could have refinanced and brought my monthly payment down Rates dropped to about 7 percent in 1998 and 1999, and then down around 6 percent by 2002.  In 2004 and 2005, rates briefly approached 5.5 percent, ran back up, and then by 2009 had returned to the 5.5 percent area.  In 2010, the 30-year fixed got down around 4% and it is currently around the 4.4 percent area.

Looking back now at my cash flow requirements to support an 8.5 percent mortgage and the fluctuations in my income, I now feel my decision wasn’t such a bad on after all.  More importantly, I see some serious problems with the current real estate market that did not exist back in 1993 through 1996.  The most glaring is that rates are historically very low.  At first glance, this might seem like a positive, and it is as long as rates stay where they are.  But what happens if they begin to rise?  Unlike the previous situation, in which mortgage holders could eventually refinance, bringing their monthly payments down, there will be no opportunity to refinance at lower rates down the road.  What you see is what your get, for as long as you own the property, if you buy at the current rates. 

Also, if rates do start to move higher, which they certainly will once the Fed begins to raise interest rates (to fight inflation) and the entire rate structure moves up, real estate prices must adjust down further, meaning that anyone that buys now will be down on price and will not want to sell at a loss, only to buy a different house of lesser value (for the same mortgage payment) because rates are higher than they were when the first home was purchased.  With no refinancing opportunities, and the very real possibility of being forced to take a loss, should the homeowner want out, current home buyers will likely be making a very long-term purchase decision if they buy now. 

Prices ultimately are based on the affordability of the monthly payment, so the higher mortgage rates rise, the lower home prices have to move to make the payments affordable for buyers.  Rising mortgage rates could indeed be the other shoe to drop for real estate.

Don’t Miss the Free Tech Brew This Tuesday! - Published in the SB News Press in April of 2011

As we move into Spring, we have another fantastic opportunity to attend a free event for entrepreneurs—The Tech Brew, Multidimensional Mega Mixer!  These events, sponsored by FD3, Maverick Angels, and SBEC (Small Business Entrepreneur Center)/Green2Gold, feature expert speakers, high-quality seminars, and are attended by a wide variety of entrepreneurs, experts and investors.  They are a must for any serious entrepreneur on the South Coast, who wants to make connections with the people that make things happen for business owners.

I have been privileged to be able to consult with many of the top advisors and angel investors in our area.  I have made some tremendous contacts, both in the investor and advisory/consulting community.  Although there are many entrepreneur-centric events that take place within our market, the Tech Brews are exceptionally valuable, because they are so well-known, so frequent, and, most of all, they are free to attend!

One of the most dynamic members of our entrepreneur support community is Alan Tratner.   Alan is a former professor of environment and energy, and the founder of the international, 40 year-old non-profit institution EEG/Green2Gold(G2G), (which is now a project of FD3—a world helping international non-profit organization). 

FD3/Green2Gold facilitates the creation of sustainable economic development incubators, hosts workshops all around the world, and has thousands of members working on developments in technology, with a strong focus on green technologies.  FD3/G2G is unique in that it also assists some 30 non-profits working in social and environmental sectors. 

Alan also serves with me on the Board and Executive Committee of the Clean Business Investment Summit of the California Coast Venture Forum, and is an Affiliate Sponsor of the Maverick Angels network.  Alan has personally presented some 4,000 workshops, seminars, and conferences, around the globe, from Stanford University to Moscow Russia, and has appeared on/in many of the world's leading media, from CNN, CNBC, the Wall Street Journal, INC., Entrepreneur, Time, Business Week, Fortune Small Business, and USA Today, to Oprah, Good Morning America and NPR, and has been featured in hundreds of radio and magazine interviews. 

Alan is a dynamo, exuding enthusiasm for all things green, technology, and business development.  He is a huge resource for local entrepreneurs, and is just one of the many experts who make themselves available at each Tech Brew, so that entrepreneurs from all backgrounds can gather the information they need to help their businesses succeed.

The Tech Brew Mega Mixer will be held on Monday, April 18^th at the Fess Parker Double Tree Resort, from 4:30 until 9.  I always advise attendees to arrive early, because a lot of the mingling and connection-making happens as people are getting situated.  Those with booths, like me, will be setting up their materials, and will have time to meet people and answer questions.  A savvy entrepreneur can get a lot of valuable, free information, just by asking a few pointed questions.

Several colleges and universities from Central and Southern California will be featured at this Tech Brew as well.  This is a great event for college students and young entrepreneurs just starting out, perhaps working on their first venture.  It is also a superb event for even the most seasoned business owners, looking to expand, or looking for help with increasing efficiency, marketing effectiveness, Internet/SEO expertise, and the like.  There is truly something for everyone interested in what makes businesses work along the Central Coast.

Of course, this weekend will feature all of the Earth Day celebrations, and we will see plenty of demonstrations of new, environmentally friendly technologies, and can meet the innovators who have created these great ideas.  Many of these same entrepreneurs will also attend the Tech Brew with booths and presentations, which should be highly entertaining and interesting.

For entrepreneurs looking to raise money, either for a start-up, development, or expansion project, the audience of the Tech Brew will be ripe with potential candidates for investment.  As we know, it is difficult, if not impossible, to get a loan, especially for a start-up business these days.  Investors, and in particular Angel investors, are probably the single most active funding source available to entrepreneurs at-present.  The difficult thing with Angels is to get in front of them to make your pitch.  The Tech Brew serves that purpose, bringing entrepreneurs and investors together in a casual, comfortable environment, which allows for direct contact and interaction.

Internet marketing, including SEO (Search Engine Optimization—getting your business to show up when someone does a search through a web browser), banner ads, skins, pop-ups, cross-linking, blogs, Facebook and other social networking approaches, are complicated, and require specific expertise.  Most entrepreneurs (including me) don’t know the first thing about any of this stuff.  As a result, many of us put off, ignore, or outright shun doing anything relating to the Internet, in terms of promoting our businesses.  The Tech Brew brings together a strong contingent of Internet marketing experts that are ready to assist with all things Internet marketing-related. 

The Tech Brew is also a great place to gather additional information about upcoming events, such as the annual Clean Business Investment Summit, coming up August 12^th at the Corwin Pavilion at UCSB, where entrepreneurs will have an opportunity to qualify to present to a large group of investors.  There are also many great seminars sponsored by Green2Gold and other organizations, many of which are free of charge, that connect local experts in a wide variety of disciplines, each of which can be critical to business success. 

Perhaps one of the most beneficial aspects of the Tech Brew is connecting with other entrepreneurs within the same or complimentary business segments.  Business owners can share ideas, discuss common challenges, and refer colleagues to outside experts they have used with success in the past. 

One of the best things about living in Santa Barbara is that there are so many talented people here locally, who are willing to share their knowledge to help others succeed.  It is like no other community I have experienced, and it is a distinct privilege to live and work here. 

As always, I will have a booth at the Tech Brew, so stop by and say hello, should you decide to attend.  For more information, and to register (it is a free event), visit:  www.techbrewmegamixers.org.  I hope to see you there!

Santa Barbara Economy Still Lagging - Published in the SB News Press in April of 2011

The rally we have experienced in the stock market over the past two years has been impressive, and has underscored the rebound in not only the U.S. economy, but the entire global economy that has positively impacted nearly every major market worldwide.  While there are some signs that the economic recovery is taking root nationally, Santa Barbara appears to be lagging the nation as a whole.

Depending on which economic indicator we choose, several scenarios, in terms of our economic future here in Santa Barbara, are possible.  Some indicators look to be improving, while others are deteriorating, at least on a month-by-month basis.  This not only makes it extremely difficult to get a sense of what to expect, but also provides economists and market forecasters with plenty of ammunition to take either side of the recovery story – a robust, sustained recovery, or an anemic, painful stagnation.  Taken as a whole however, the indictors look to me to be showing that Santa Barbara is lagging the country overall, and lagging by a year or more. 

According to S&P/Case-Shiller, U.S. median home prices peaked at around $272,000 during the second quarter of 2006.  The current median home price is around $160,000.  With the exception of a few minor bounces, prices have been declining steadily from the 2006 peak and have not bottomed yet.  This decline represents a 41% decline from the peak (and counting).

Median prices in Santa Barbara County peaked much later—in July of 2007—according to the California Association of Realtors, (although the median price was as high as $859,000 in June of 2006).  The current median home price in Santa Barbara County is $366,000 (as of January 2011), which represents a 57% decline—yes you read that right!  For the city of Santa Barbara, we peaked in October of 2007 at $1,275,000.  The median price as of January 2011 was $820,000, which represents a 36% decline.  This discrepancy between the county and city declines would suggest that the north county has experienced some very dramatic price drops from the peak.

Prices for the city of Santa Barbara do appear to be starting to rebound a bit, at least on the median price level, although it seems that houses priced in the sub-$1 million range are selling much more briskly than those above $1 million.  It is too early to tell if prices are nearing a bottom yet, and as I wrote last week, if interest rates start to rise, (which they will), housing prices still have a good ways to fall before reaching bottom.

Unemployment peaked for the U.S. at 10.1% in October of 2009, according to the Bureau of Labor Statistics, and has now fallen to 8.8%--the lowest rate we have seen since March of 2009 (before the peak). 

As of March of 2011, we had 21,000 people officially unemployed in Santa Barbara County, which represents an unemployment rate of 9.6% (Employment Development Depart of the State of California).  We did not reach our peak unemployment rate of 10.4% until January of 2010, three months after unemployment peaked in the country as a whole.  We currently have an unemployment rate that is 0.8% higher than the country.  Since both rates appear to be declining, we can’t know if we will continue to lag behind the nation through the bottoming of unemployment, but we have a good ways to go to make-up the current difference, and an even longer road to a reasonable unemployment rate.

National GDP (Gross Domestic Product) was just reported this week for the first quarter of 2011, at an annualized rate of 1.8%.  This compares somewhat unfavorably to the 3.1% annualized GDP growth we achieved in the fourth quarter.  (The fourth quarter is typically strong, due to the holidays.)  Quarterly GDP growth peaked in the first quarter of 2006 at 5.4% annualized growth, although growth slowed to only 1.4% in the second quarter of 2006.  

The U.S. economy grew at around 1.9% through 2007, with the first signs of trouble coming in the first quarter of 2008 with our first quarter of negative growth -0.7%).  Not surprisingly, the worst quarter was the fourth quarter of 2008, just after the financial market implosion, with GDP growth of -6.8% (annualized).  Negative GDP growth continued through the first half of 2009, before turning positive in the third quarter.  In both 2009 and 2010 we have had strong fourth quarters (+5% in 2009, and +3.1% in 2010).  Although I believe we will only see about 2% to 2.5% GDP growth for 2011, we are definitely growing (although slowly), and have turned the corner from recession to recovery.  The U.S. economy was flat in 2008, contracted by 2.6% in 2009, and rebounded in 2010 to expand by 2.9%.    

The Santa Barbara-Goleta-Santa Maria Metropolitan Statistical Area grew by almost 4% (3.92%) in 2007, compared with less than 2% for the country as a whole that year.  Our area grew by about 1.5% in 2008, but lost ground in 2009, with negative growth (-0.66%).  The Bureau of Economic Analysis has not released the 2010 GDP numbers for Santa Barbara-Goleta-Santa Maria, so it is difficult to draw any conclusions on the comparison between U.S. GDP and local GDP trends.  Also, GDP bounces around so much that defining a trend is problematic at best.  Still, it does appear that the U.S. economy experienced a decline in GDP growth first, with our local economy following about one year behind. 

On balance, it seems that our local economy is lagging the country as a whole; at least it has been through the recession and recovery to this point.  This begs the question: Will our economy play a bit of catch-up, or are we destined to continue lagging?  A continuing lag would mean that it will be another year or longer before we see local unemployment come down significantly and local GDP growth improve. 

The bigger question is: Can the local economy stand another year or more of weak economic activity?  The answer to this may lie in the ability and willingness of local commercial property owners to negotiate more acceptable/reasonable/affordable rental rates with local business tenants.  As it stands, we are seeing far too many locally-owned businesses fail and close their doors for good, only to be replaced by national chains.  In some cases, businesses are leaving because they cannot afford their rent; leaving vacancies that are not being filled by any new businesses.  One need only drive down the streets of Santa Barbara and Goleta, in the business districts, including State Street, to see the large number of empty commercial/retail spaces. 

Some property managers in town have stated recently that many new businesses are coming into town and are willingly signing up at “good” rental rates.  I have heard about several national chains that were scheduled to open locations in town, but have not moved forward with these plans to-date.  Not only is having a lot of empty space along our major business thoroughfares depressing and bad for the remaining businesses, but it’s also a lose/lose for landlords as well—they have empty spaces, which are always tougher to rent than occupied spaces; and they are not receiving any rents as long as those spaces remain unoccupied.  Often only a relatively small discount in rent would be required to keep tenants in a space. 

It does appear that the national economy is improving, although not at a pace that would seem necessary to justify the strong performance of the stock and commodities markets over the past two years.  On a local basis, it does seem that we are still lagging pretty far behind the country in terms of economic activity.  With the threat of already very high commodity prices, including gasoline (which definitely affects the local economy due to our heavy focus on tourism), rising interest rates, rising inflation, the continuing global debt crisis and unrest in the Middle East, there is still a lot to worry about. 

Prudence demands that we plan for a long, drawn-out recovery with continuing slow growth well into 2012 for our local economy.  I tend to be overly optimistic, but given the current economic environment, local business owners should hope for the best, but be realistic about the time it will take to drive revenues back to good, or even acceptable, levels.  

Real Estate as an Asset Class - Published in the SB News Press in April of 2011

Most advisers use software programs to produce recommended asset allocations for investors.  These programs normally use long-term historical averages for risk factors and returns for each asset class, along with the Markowitz Efficient Frontier, to produce a recommended portfolio at a given level of assumed risk.  The “assumed risk” part of the analysis typically comes from a series of questions that the client/investor is asked, relating to their feeling about various scenarios, such as how they would feel if their portfolio fell in value by a certain percentage.  As these programs have evolved, they have begun to include more asset classes, such as gold and real estate, in addition to the traditional classes, such as stocks, bonds and cash.  For investors who own real estate in expensive areas like Santa Barbara, where real estate values are still comparatively high, these programs may recommend too much real estate for the investor’s portfolio.

I have written extensively about these programs and more specifically about how using historical averages for risk and return is a poor method for recommending allocations for investment portfolios.  (Historical averages would not have been very helpful for an investor putting money into the financial markets in early 2008, for example.)  Asset allocation programs also typically recommend a sizable allocation to foreign markets, which I do not agree with (as last week’s column highlighted).  In a nutshell, I disagree with using asset allocation programs at all.  They are far too general and rely, again, on long-term historical data that has very little to do with the current and future market conditions investors will face.

Depending upon how one answers the questions in an asset allocation program, the recommended allocation will include anywhere from 5 percent to as much as 30 percent be invested in real estate.  For some strange reason, many advisors will make this recommendation, knowing that the investors owns a home worth a significant portion of their total net worth—sometimes 50 percent or even more of that total.  Early in my career, which has spanned over 20 years, conventional “wisdom” was that only liquid assets should be considered when creating an asset allocation.  For this reason, the personal residence was typically excluded from the analysis (which was ridiculous). 

I am from Texas originally, and in Texas, this kind of thinking wasn’t as dangerous because the average single-family home was worth $100,000 or so.  For an investor with several million dollars to invest, excluding $100,000 in real estate wasn’t too damaging.  However, for a Santa Barbara resident with a home valued at $1 million, which isn’t too far above the median home price here in town, and who may have a $2 million investment portfolio, excluding the personal residence when formulating an asset allocation could be a serious mistake.

In the above-stated scenario, the personal residence represents fully one-third of the total net worth of the investor.  Adding even an additional 5 percent of the $2 million investment portfolio to real estate would exacerbate an already massive overweighting in real estate for this investor.  By definition, if the advisor (and the computer program he or she was using to generate the asset allocation) was recommending that 5 percent of the portfolio should be in real estate, this theoretical investor would therefore be overweight real estate by $850,000, or by about 28 percent (5 percent of $3 million is $150,000, so if the investor owns a $1 million home, they have $850,000 more in real estate than the program would recommend). 

If anything, the advisor should, at a minimum, not recommend that the investor place even more money into real estate.  More to the point, the advisor should be recommending ways to reduce exposure to real estate, or reduce risk associated with real estate.

An even more concerning aspect to the issue of real estate exposure for those living in expensive areas and owning real estate, is that most don’t own their houses outright, but instead hold mortgages (debt) on them.  In the investments business, this is referred to as leverage.  If the house were a stock trading on an exchange, we would call it margin.  A mortgage has the exact same impact on the risk associated with real estate as margin does for a stock transaction.  The only difference is that with margin, the investor could get a margin call, requiring more cash to be deposited, whereas with a mortgage, there would not be a call no matter how low the value of the house fell.

With regard to the investor’s asset allocation, there are two ways to look at a house with a mortgage:

1.) The investor could include the total value of the property in their asset allocation
2.)  The investor could include only their equity position in their home—home value less their mortgage

Both methods involve some challenges.  With option 1, the asset allocation is more accurate for analysis and planning, but does not address the associated risk of loss (due to the leverage involved).    As an example, if the investor owns a $1 million home, but has a $500,000 mortgage, this option would have the full $1 million represented in the asset allocation.  However, due to the mortgage (leverage), a given percentage decline in the value of the property will result in double the percentage decline in the investors equity position in the home.  (If the house fell in value from $1 million to $800,000, or by $200,000 (20%), the mortgage does not change—it’s still $500,000 in this example—so the entire $200,000 comes out of the investor’s equity, causing that equity to fall from $500,000 to $300,000, or by 40% (twice the decline in the home value).  Therefore this method captures the dollar risk more accurately than option 2, but does not reflect the potential for percentage losses.  (The investor in this example has fully twice the percentage risk one would normally associate with owning a $1 million outright.)

With option 2, the investor will have a more accurate representation of their dollar exposure to real estate, but their asset allocation will under-represent their total real estate risk in dollar terms.  Using our same example, if the investor only includes the $500,000 equity position they have in their home, the asset allocation will not reflect the other $500,000 in dollar exposure they have to real estate.  This could potentially cause an over-allocation to real estate, if the investor uses an asset allocation program and only inputs a $500,000 exposure to real estate, when the reality is that they have a $1 million exposure. 

I would use the first method, although again, it does not fully capture the true risk to the investor, if one uses an asset allocation program (which is why I do not use these programs). 

Even if one believes in using an asset allocation program, it is advisable to include the personal residence as a real estate investment, when generating an asset allocation recommendation.  For most investors, however, the program would recommend an allocation to real estate that is far less than their actual exposure.  What to do?

Contrary to what many advisors might recommend—adding even more real estate—theoretically, the investor in this case would want to find a way to reduce exposure to real estate.  One possible method of doing this would be to short real estate through selling short REITs or some other real estate stocks.  Another, more favorable method would be to use an ETF that provides short exposure to real estate.  But be careful!  Shorting REITs can be tricky for several reasons.  First, they don’t necessarily track real estate prices well.  Also, they typically pay high dividends, so if you are short, you are responsible for paying the dividends.  Also, many of the short ETFs use REITs, so you have the same issues if you buy an ETF that is short real estate. 

An indirect way to protect your downside would be to short financials, such as banks that make loans for real estate purchases.  As we saw, the banks get hammered when real estate bubbles burst, so shorting the banks would act as a hedge against price declines in real estate.

All of this is a bit academic and not very timely, to say the least, since real estate prices are down about 40 percent here in town from the peak, and we have already seen the negative impact on the banks, etc.  However, this discussion will hopefully inform investors of the dangers of depending too heavily on asset allocation programs, or the advice of advisors blindly using these programs and recommending large exposures to real estate.

International Diversification Simply Doesn’t Work - Published in the Santa Barbara News Press in April of 2011

When I was a portfolio manager with Wells Fargo, I also served as an analyst, covering certain stocks for the portfolio managers throughout the bank to use for managing client portfolios, etc.  Not long after I joined the bank, I performed an analysis of the model portfolio Wells used at the time as the basis for their stock allocations for most client portfolios. 

The Wells model portfolio included a sizable allocation to international companies, which I found to be of concern.  While most investment advisors these days will tell clients that it is important to own investments from outside the U.S. markets to diversify (reduce potential risks), I have always felt that this was a mistake. 

Through analyzing the Wells model portfolio, I reviewed the sources of revenues for all of the companies included in the portfolio.  What I found was that the U.S.-based companies in the portfolio as a whole had a significant amount of revenues generated from foreign markets.  My conclusion was that, even if you accepted the conventional thinking that every stock portfolio should contain foreign investments, this model portfolio was heavily overweighted internationally, due to the additional international revenues that the U.S. companies were generating.

Some may argue that what matters is not where the revenues come from, but rather where the company is headquartered.  I disagree completely.  The risk and the opportunity reside in the revenue generation potential of the company.  Even though McDonald’s, as an example, is headquartered in the U.S., it only generates about 40% of its revenues here; 60% come from outside the U.S.  One need only watch the fluctuations of McDonald’s stock to see that the performance and the risk in the stock are directly driven from their financial performance, which in turn is a direct result of their revenues and earnings.

Needless to say, the powers that were at the time, were none too happy with me for my research report, and refused to publish it to the other portfolio managers throughout the country.  (Just for the record, Wells is a great company, and I haven’t been there for years, so I don’t know how they manage money these days, and I am sure they do a great job for their clients.) 

My experience with Wells on the issue of international diversification to reduce portfolio risk underscores what I believe to be flawed thinking that is pervasive throughout the industry.  Just about any advisor out there will tell clients that in order to reduce their risk, they need to add international investments to their portfolios.  In fact, there are multiple studies that have been done over the years that appear to prove that owning foreign investments does actually reduce risk.  But what is risk?

Most of us in the investment management field define risk as portfolio volatility—the fluctuation of portfolio values over time around the mean return.  Investors think of risk in an entirely different way—they see risk as the potential for losing money.

If we use the investor’s definition of risk, the benefits (or lack thereof) associated with international diversification are easy to see and understand, from the investor’s point of view.  Diversification is the allocation of assets into various types of investments to reduce overall portfolio risk.  Again, using this definition, portfolio managers typically recommend purchasing international investments to improve diversification, thereby reducing overall portfolio risk.  The idea is that, at times when U.S. investments perform poorly, the international investments will go up, offsetting the losses from the U.S. investments, or will at least not go down as much as the U.S. investments, reducing the overall negative impact on the portfolio.

Investment professionals use what is called correlation to mathematically calculate the relationship between various asset classes, and to “prove” that international diversification works—reduces portfolio risk.  The problem with their “proof” is that they calculate their correlation coefficients, based on historical performance for the various asset classes. 

It is true that, if you use a very long time horizon, and back-test the relationships between U.S. and international assets, the correlation coefficients can show low correlations, meaning that U.S. and international assets do not move in the same direction at the same time, at least by the same amount.  In other words, these calculations appear to show that owning both U.S. and international investments in the same portfolio works—reduces risk.

However, what investors care about, or should care about, is losing money, as discussed above, and not simply reducing portfolio volatility.  Also, while looking at long-term averages might help investment professionals justify international investments, the reality is that it only takes one significant, negative event, such as we had in late 2008/early 2009, to crush an investor’s performance and completely disrupt and possibly delay their retirement plans.

To underscore my point (which is that international diversification doesn’t work), let’s look at some of the most popular international indexes and their returns through the market collapse of 2008 and 2009.  One popular international investment vehicle has been the BRIC countries—Brazil, Russia, India and China.  The Morgan Stanley index that tracks these markets dropped by about two-thirds around the time that Lehman Brothers failed.  During the same time-period the S&P 500 fell by about half (significantly less than the BRIC index).  The EAFE Index (Europe Australia and the Far East) tracks 21 indexes from these markets.  It also fell by about two-thirds during the same time-period; again, substantially more than the S&P 500.  In fact, if we look at just about any index representing almost any foreign equities market outside the U.S., we find the same result—the foreign market declined more than the U.S. equity markets during the same turbulent time-frame. 

This is not what is supposed to happen, if we believe the proponents of international diversification!  What should have happened is that the foreign markets should have gone up, or should have at least performed better than the U.S. markets.  Regardless of whether one defines risk as portfolio volatility, or losing money, diversification simply failed to protect investors from risk.

One could argue that the disruptions in the world financial markets were so extreme, so unexpected, so coordinated, that of course diversification failed to protect portfolios from losses.  If the proponents of international diversification could somehow guarantee us, or at least assure us, that nothing like this will happen again, maybe we could overlook the obvious.  Unfortunately, the world financial markets are forever linked (which is a key reason why back-testing correlation coefficients doesn’t yield usable data), making it much more likely that we will experience more significant market disruptions on a global scale in the future.

Returning to my original position, which was formulated many years ago, I firmly believe that investors gain plenty of international exposure by simply investing in top-quality, U.S. firms that generate significant revenues outside the U.S.  In other words, if an investor wants exposure to a foreign market, buy a U.S. company that does business there, plain and simple.  One need only review the financial filings of companies to see where they are doing business, so the process of evaluating and selecting viable candidates is not difficult or time-consuming.

If you agree with me up to this point, then there can be only one good reason to invest in a non-U.S. company—to make money.  If there is a company in a foreign market that is an outstanding prospect, that has a competitive advantage over its U.S. rivals, has dominant market-share, superior products, management, etc, etc, then, and only then, may it be a possible candidate for investment.  In other words, buying non-U.S. companies simply to diversify is a bad strategy and will not work.  So, unless the foreign company is a better prospect that it U.S. counterparts, there should be no reason to purchase it.

Investors should not take my word for this (or anything else).  Question your advisor.  Ask them why they are recommending foreign investments (if they are).  If they tell you its for diversification, don’t just accept it.  Make the advisor support his or her position and show you a valid reason for their recommendation.  It’s your money!  Unless they can convince you of the merits of each and every recommendation, just say no!